What You Need to Know About the 529 College Savings Plan

Saving for your child's college education? You've got options and the most popular is the 529 College Savings Plan. In today's post we give you the basics in plain English, plus some strategies and advice for parents who want to start saving.

Unless you've been living under a rock for the past 10 years, you know that college is expensive. Really expensive. Unfortunately, college costs don't seem likely to be seriously declining anytime soon so it's important to start thinking about the best ways to start saving for your child's college education. Luckily, there are a variety of options for parents, grandparents and future students alike. Today, we're going to take a look at the 529 College Savings Plan, a state-run program designed to help save for educational costs.

First things first: a little advice for parents...

Before we get into the details of the 529 plan, we want to remind you that when it comes to savings, your retirement should be the first priority. By the time your child is getting ready to pay for college, she'll have plenty of options to help her pay for her education (think scholarships, financial aid, student loans and grants). When it's time for you to retire, you'll only have one: your retirement savings. So please, please, please do not scrimp on your retirement savings in the name of your child's college fund. That being said, if you're saving a healthy amount each month for your retirement, you'd be well advised to start putting some money away for Junior's future education.

What is the 529 Savings plan? What can I use it for?

The 529 plan is a state-run savings program that provides substantial tax benefits to individuals saving for education costs. If you're saving for your child's college education, there are two types of accounts: the College Savings/Investment plan and the Prepaid plan.

The 529 College Savings/Investment Plan

The college savings/investment plans are similar to 401Ks in that they invest your contributions in mutual funds, meaning that the growth rate is dependent on the underlying fund's performance. The plans are managed by either the state's Treasury Department or outside investment companies hired by the state.

Here's what you need to know:

Because this plan is offered by state governments, the tax benefits and details will vary depending on your state. Find the details on your state's 529 plan here.

Most states provide asset allocation options based on the recipient's age. This means that investments become increasingly conservative as the student approaches college age.

The majority of states allow donors to save up to $300,000 per recipient, and rarely have income limitations or age restrictions.

529 withdrawals can usually be spent on room and board, as well as books and computer costs.

Withdrawals not spent on education-related expenses are subject to a 10% federal tax penalty.

Donors can transfer any unused funds to other children or grandchildren to use for college expenses.

The 529 Prepaid Plan

If you've already got a pretty good idea of what Junior's alma mater will be, a prepaid plan might work for you. These plans let you prepay all or some of the costs of tuition at the current tuition rate. The appeal is that, historically, tuition rates have grown far in excess of inflation, so the prepaid plan allows you to lock in the current rate.

A few things to keep in mind about this type of plan:

This can be used to pay for tuition at public universities. The snag is that only about a quarter of states currently offer prepaid plans.

The plan is currently accepted at 270 private colleges, so make sure to check this list if you're thinking about starting a private college prepaid plan.

You can use the savings at any of the participating colleges, and can start saving with as little as $25.

What if I have more than one child?

If you have more than one child or are creating a 529 account to help pay for your grandchildrens' college costs, you have a few options.

Option 1:Create a separate account for each child. Assuming that you deposit the same amount each year, this will allow you to take the most advantage of tax benefits. If you are concerned about saving the same amount for each child, make sure that you open each of their accounts at the same age. The standard portfolios are designed with just one beneficiary in mind, so this may reduce the hassle when it comes to choosing your investments.**

Option 2:Start with a single account then add more. This option allows you to start saving without having to provide the minimum funding amount for more than one account. It's a good way to get the ball rolling while you save up enough to open a second account.**

Option 3: Start with one account and change the beneficiary after the first child has finished college. _Because standard plans invest more conservatively as the beneficiary approaches college age, you'll need to make sure that you customize the investment portfolio. Using a single account prevents you from maximizing your tax benefits, but it does allow you to save money on set-up and maintenance fees and minimums.*

Option 4: Focus on funding either the oldest or youngest child. Why does this make sense? If the two children are far apart in age, you may want to contribute more to the oldest child's account, because the funds won't have as much time to accrue interest. On the other hand, because college costs are outpacing inflation, they may be significantly greater for the youngest child than the oldest.

Will the savings effect my child's financial aid eligibility?

If your child can apply for financial aid as an independent, the answer is no._ The 529 account is considered the asset of the donor (a.k.a. mom, grandpa, etc) rather than the beneficiary (a.k.a. Junior).

If your child is still considered a dependent, as most 18 year olds are, the longer answer is not much_. Because the government doesn't want to strip parents of their retirement savings, the amount of money you can shield from consideration on your child's FAFSA will depend on the age of the older parent. The closer you/your partner are to retirement, the more money you can shield. Here are some examples from Jodi's post on savings and financial aid eligibility: In a 2-parent household, if the oldest parent is 52, the family would be able to shield $49,200 in 529 savings money as well as the cash from other taxable accounts such as checking, savings or brokerage accounts. A 60 year old parent could shield $61,400.

Regardless, you're better off saving as much as possible. But then, you knew that already, right?